Thursday, January 3, 2019

Final Decision Checklist

I had previously mentioned a checklist that I use as the last thing I look at before making an investment in a stock. As I'm thinking about spelling out my process and philosophy in regards to forming a potential Registered Investment Adviser, I thought I'd clean up the wording a bit, and paste it here if anyone else is interested. One important note though: I've come to believe that developing a full image in one's mind of how a business operates, competes, allocates capital, takes care of customers, etc. is much more important than checking off certain items on a list (i.e. Holograms > Checklists). Combined with developing that image is the necessity of only investing in those things that seem like obvious bargains. But the final checklist serves as a great way to help stay disciplined, and hopefully sidestep some avoidable errors. Everyone's will probably be different and evolve over time, but here is mine in its current state.

Final Decision Checklist (the final checklist to go through before putting any capital to work)

1. Are you tired?
  • "We didn’t know, when we started out, this modern psychological evidence to the effect that you shouldn’t make a lot of important decisions when you’re tired and that making a lot of difficult decisions is tiring.... I cannot remember an important decision that Warren has made when he was tired." –Charlie Munger
2. Did you make this investment decision while the market was closed, so that current price moves aren't impacting your judgment?
  • “Sleep on it” is good advice before buying/selling.
3. Have you done enough work, and are you sure this is within your circle of competence? 
  • "We will never buy anything we don’t think we understand. And our definition of understanding is thinking that we have a reasonable probability of being able to assess where the business will be in 10 years." –Warren Buffett
4. Is the balance sheet conservative to allow the company to endure—and hopefully take advantage of—even the most difficult of economic environments?

5. Is the management team comprised of the kind of people you want to partner with, and are their interests clearly aligned with your interests? It’s not worth being business partners with people you don’t like and admire, and as an owner of the business they are running, you are essentially their partner.

6. Is this a good business? 
  • It doesn't necessarily have to be a long-term "compounder" type of business, but it needs to provide real value for its customers, clients, etc…. i.e. a Win-Win with all six counterparties (customers, suppliers, employees, owners, the regulators, and the community).
    • “Win-win is as much safety as it is compassion. The sustainability of any organization ultimately rests on delivering a win-win partnership with counterparties. Any other relationship will eventually lead to a fatal flaw that will eventually be corrected. Be constant – Be Kind.” –Chris Begg
7. Do you have downside protection? This will largely come from:
  • Paying close to (adjusted) net asset value, encompassed within a business that has solid earning power (even if temporarily obscured) and some advantages protecting that earning power, even if it’s within a cyclical business and the size of the moat may be hard to estimate.
  • And/Or a moat that protects a minimum, and conservatively-estimated, level of earnings—and then paying a fair to good to great price for that level of earnings. The price paid will largely be a judgment call based on the size of the moat and the reinvestment prospects within that moat (i.e. ability to invest capital at high rates for a given duration of time).
  • The direction of the moat (shrinking or expanding) is more important than the size of the moat.
    • “We think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year.” –Warren Buffett
    • “In my view, widening the moat is more important than the width of the moat. Everyone is attacking a company’s moat, so the question is not how wide it is, but whether it is widening at a faster pace than competitors are filling it up. Innovation is central to the idea of widening a moat.” –Rob Vinall
  • And while a judgment call on quality vs. price, remember that it should look obvious if you have a full picture of things: “Part of the reason that we have a decent record is [that] we pick things that are easy. Other people think they're so smart they can take on things that are really difficult. That proves to be more dangerous. You have to be shrewd, and you have to be very patient. You have to wait until something comes along which at the price you're paying is easy.” –Charlie Munger
8. When thinking about price vs. value: 
  • Is there at least three times more upside than downside? (e.g. If downside under a worst-case scenario is 50%, I need at least 150% [2.5x return] upside.) 
  • Do I think this investment is likely to double in 3-5 years? (~15-26% IRR)
  • And if I'm wrong, is there a high probability that my downside is waiting 10 years (because it’s a good business that is growing) for a double as opposed to losing money? (~7% IRR)
  • There may be some situations where your downside is so limited if you can hold longer-term that even if the expected IRR may be 15% over a 2-3 year period instead of longer, it could still be worthwhile (e.g. A bond you know with extremely high confidence will pay off at maturity, and you can hold until maturity; Or at times, buying Berkshire Hathaway at a low multiple of understated book value, and also a decent discount to fair value.).
  • One of the main advantages you can have as an investor is looking out 5-10 years when thinking about value—as opposed to thinking shorter-term—and comparing that value to the price today.
9. Is this business almost certain to be making more money 10 years from now, and can it increase its long-term value in a tough economic environment (e.g. by buying stock, taking business from weaker competitors, treating weaker customers and suppliers well in order to build long-term trust, etc.)? 
  • Downside via a current moat or asset value isn't enough…. The business must also be something that is almost certain to be making more money in 10 years. All six key investment traits should be present—to varying degrees and sometimes temporarily obscured (unless it’s a special situation investment with a given catalyst):
    • Downside 
    • Cash Flow (Sustainable Earning Power) 
    • Growth (Reinvestment Opportunities)
    • Antifragile (ability to take business advantage in tough environments—including high inflation—even though the stock may go down with a declining market)
    • People 
    • Price
10. Am I viewing this as a business and not just a stock? Am I taking the mindset of buying the business outright, and retaining management?  
  • "[Charlie and I] don’t consider ourselves richer or poorer based on what the stock does. We do feel richer or poorer based on what the business does." –Warren Buffett
11. Am I sizing the position appropriately? 
  • While you need to concentrate your portfolio in your best ideas, you also need to remember Howard Marks' story about the race with one horse, where what seemed like a sure thing wasn't, because the horse jumped the fence and didn't finish the race..... Unexpected things happen and you won't see them all coming. 
    • The Marks story, via Peter Bevelin's All I want to know... book: “It can always get worse than you think. I love this story from Howard Marks: ‘I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect. Maybe ‘worst-case’ means ‘the worst we’ve seen in the past.’ But that doesn’t mean things can’t be worse in the future.’”
  • And it may not be a bad idea to only buy 1/3 of a position at first, especially if you've been following the company for less than 6 months. 
12. No FOMO, No Sunk Costs, and No Acting Out of Boredom.
  • You have to be willing to watch plenty of things you thought were good but not good enough go on to perform well and be indifferent about it; that’s part of the game. 
  • You can’t let putting time and effort into something influence your willingness to invest in it—be ready to walk away and move on, with equanimity to the eventual outcome, as soon as you see something that you don’t like. 
  • And always do the work before investing, realizing that you’ll miss plenty of things that go up while you’re finishing the work that needs to be done before investing in anything.
  • So, have you done the work that needs to be done? And are you sure you’re not settling just because you’ve put in the work?
  • And remember, great investors have often made mistakes when they either had little to do (do-something syndrome) or had too much cash on hand. You must stay disciplined, and then remain patient for however long it takes.